Ground Up Development
When most new investors imagine real estate development, they likely picture ground up projects. That is, most people equate real estate development with converting a vacant piece of land into a newly constructed building. This process is referred to as ground up development. And, while it’s not the only type of development, it can be one of the most profitable. But, it also entails a tremendous amount of risk. As such, we’ll use this article to provide an overview of ground up development.
Specifically, we’ll cover the following topics:
- What Is Ground Up Development?
- Ground Up Development Steps
- Risks to Ground Up Development
- Final Thoughts
What Is Ground Up Development?
Real Estate Development Overview
Real estate development is the business process of improving either raw land or existing structures. Developers use these real property improvements to increase the value of that property. Many real estate developers focus on a particular development strategy (e.g. historic tax credit renovations, value-add acquisitions, single-family home communities, etc.).
Regardless of strategy, real estate developers focus primarily on the financials behind a deal. A successful developer will underwrite a potential deal to ensure that the total future revenues justify the total development costs. If the return on investment doesn’t make sense, the developer will either alter the deal’s plans or not pursue it at all.
What Ground Up Developers Do
As the name suggests, ground up developers focus on converting a piece of unimproved land into operating real estate. That is, these developers create new property improvements from a previously unproductive (or less productive) piece of land. Depending on the deal, ground up developers may then choose to either A) sell that new building, or B) lease it to tenants.
For example, let’s start with a parcel of unimproved land. A ground up developer could look at that land, design a plan for improving it into a series of townhomes, figure out how to finance the construction of those homes, receive local permitting approval, then supervise the construction of those townhomes. Following the construction process, this developer could continue to lease the homes for rental income, sell them to another real estate investor, or sell them to individual homeowners.
Ground Up Development Steps
In this section, we outline the major steps for any ground up development. The unique nature of a given deal may require additional steps, but you can expect to complete all of the below steps for any ground up development.
Step 1: Identify the Parcel, Complete Initial Designs, and Underwrite the Deal
Ground up developers typically look for one of two types of land parcel: 1) a vacant parcel, or 2) one with an older building to be razed after purchase. Regardless of approach, developers must first identify a parcel to purchase. Then, you must work with an architect to complete initial design plans. These designs will tell you the number and type of units, which translate into a projected rent roll – necessary to begin the underwriting process.
While the details of underwriting are beyond the scope of this article, the objective of underwriting is straightforward: making sure a deal’s numbers work. That is, 1) do the projected future rents cover projected operating expenses and debt service, 2) does the associated net operating income translate to a valuation justifying acquisition and ground up development costs, 3) what are the deal’s equity requirements, and 4) do the projected future cash flows meet your minimum required returns?
Step 2: Line-up Financing
With solidified plans and underwriting, developers can line up their financing. For debt financing during the construction period, lenders will, at a minimum, require your full underwriting template (generally referred to as a pro forma). They will also want to see the design/construction plans and projected timelines.
If you’re raising equity funding, as well (i.e. bringing on outside investors), their requirements will vary. Most investors will also want to see the pro forma and design plans. Additionally, investors will want to see projections of future cash distributions and ROI, as they will have their own required returns. Most investors will also want to see a demonstrated track record of successful deals before investing with a developer.
Step 3: Make an Offer Contingent Upon Zoning Confirmation
Next, you need to make a purchase offer and go under contract with the seller. However, to mitigate zoning risk (i.e. a municipality rejecting your construction plans), the offer should be made contingent upon zoning confirmation. Most local zoning boards offer some form of zoning confirmation letter. While not full approval, these letters affirm that a developer’s plans align with local zoning requirements. By including a zoning contingency, it lets you exit a deal before closing without losing your earnest money deposit if you fail to receive a zoning confirmation letter.
Step 3a: Apply for Rezoning or Special Use Permit, as Required
However, many ground up development plans involve construction that doesn’t align with a parcel’s existing zoning. For instance, a parcel may be zoned for light industrial use but you want to build an apartment building. Depending on the specifics of the deal, this situation likely requires applying for rezoning or a special use permit.
Either of these options can take a long time and cost a lot of money. If it is not possible to complete the process during the feasibility period, ground up developers should consult local zoning specialists or attorneys prior to closing on any deal that hinges upon a change in zoning status. You don’t want to find yourself in a situation where you’ve bought land that does not support your ground up development plan.
Step 3b: Complete Other Pre-Closing Due Diligence Items
In addition to addressing zoning issues, any development deal should include certain standard due diligence items prior to closing. At a minimum, these items include title research to confirm clear title, an ALTA survey for a detailed parcel map and how it relates to title, and a Phase I Environmental Site Assessment (ESA) to confirm no environmental hazards require further research and/or mitigation.
Step 3c: Confirm Financing and Close On the Purchase
Assuming you clear all due diligence and feasibility thresholds, you’ll eventually close on the deal. Closing (or settlement), is the legal process where you formally purchase the land from the seller. If using debt financing, this typically occurs concurrently with closing on the acquisition/construction loan. Depending on the structure of any additional equity financing, you will either receive those funds at closing, shortly prior, or afterwards as a reimbursement.
Step 4: Submit Stamped Architectural and Engineering Plans for Permitting
With ground up developments, municipalities need to confirm building plans before you begin construction. After closing on the purchase, developers – typically via their general contractors (GC) – submit stamped architectural and engineering plans for permitting approval. During this process, you may have to go back and forth with the local building department to adjust details of your plan. Eventually, you will receive approval in the form of a building permit.
Step 5: Complete Construction
For the developer, the construction period entails overseeing the GC’s progress, maintaining associated accounting records, and submitting regular construction loan draw requests. Upon construction completion, the GC or developer will apply for a certificate of occupancy, or CO, from the municipality. Once the CO is issued, the property can be occupied.
Step 6: Market the Property for Lease or Sale
Following receipt of the CO, developers take one of two paths, depending on their deal exit strategies. If holding the property to rent, developers will work with a property management company to lease up the units and begin stabilized operations. If planning on selling the property immediately (either to another investor or individual homeowners), developers will work with real estate brokers to market the property for sale.
Step 7: Close on Permanent Financing (As Required)
If planning on holding the property, leasing it up as quickly as possible is critical to securing permanent financing (i.e. the long-term loan that replaces your short-term construction loan). Before lenders approve a permanent mortgage, they’ll want to see that a certain percentage of the building’s spaces have been leased (often 95% or higher). However, most developers identify their permanent lenders well before this period. That way, they can have all loan paperwork in place, allowing them to apply as soon as they hit the lease-up threshold.
Risks to Ground Up Development
Sunk Cost Risks
Before actually breaking ground on any construction, developers must make significant cash outlays. Developers pay for feasibility studies, legal fees, zoning applications, and architectural designs, among other costs, before receiving municipal approval. A failure to receive that approval – which can certainly happen – means developers forfeit all of these initial costs.
As stated above, developers can mitigate these risks by requesting zoning confirmation letters during the closing process and including a zoning contingency in the purchase agreement.
Unforeseen Construction Issue Risks
Construction on larger ground up developments can last for multiple years. During this time, countless unforeseen issues can arise to derail the development. For instance, an economic downturn may either dry up financing sources or make the project no longer economically viable. Or, an environmental issue could arise (e.g. discovery of chemicals in groundwater), causing a halt in construction and millions of dollars in remediation work.
Successful ground up development requires a tremendous amount of experience, and it entails significant risk. Rather than tackling a development project as a new investor, we highly recommend working with an established developer like High Peaks Capital.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available ground up development investment opportunities.